Structuring the Loan in Loan Regime Split Dollar
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Written by TJ Telford, Area Vice President for BFB Gallagher and Kirk Sherman, Partner at law
firm of Sherman & Patterson, Ltd
Loan regime split dollar (LRSD) is becoming a staple in credit union executive compensation packages.
Over the last 15 months, the number of credit unions using LRSD has grown by 40%.1 Twenty new
credit unions added LRSD each quarter. Boards like LRSD because of its favored tax treatment for the
executive and cost recovery for the credit union.
LRSD designs vary widely. They—
• Use different insurance products.
• Vary the timing of the credit union’s deposits into the policy.
• Impose a wide spectrum of vesting and forfeiture requirements.
• Allow access to the funds in the policy at different times.
• Divide the death proceeds in different ways.
Notwithstanding these variations, all LRSD designs have two things in common. First, the credit union
pays funds into a life insurance policy and is repaid those funds at a later date. This creates the “loan”
element for which the arrangement is named.2 Second, all credit union loans accrue interest. The
executive must either pay the interest or report it in income.3 If payments are required, interest can be
paid annually or can be accrued and compounded and paid from the policy death proceeds.
LRSD loans can be structured as demand loans or term loans, and they can be recourse or nonrecourse.
The loan structure selected will largely determine whether the arrangement succeeds or fails.
Demand vs. Term
A critical determiner of the success of LRSD is the interest rate charged on the credit union’s loans. The
lower the interest rate, the more efficiently the arrangement operates. The choices between a demand
loan and a term loan, and if a term loan the length of the term, determine the minimum interest rate.
A simple test separates demand loans from term loans. According to IRS regulations, a demand loan is “any
split-dollar loan that is payable in full at any time on the demand of the lender.”4 All other loans are term loans.5
Caution: Some designs claim demand loan status without an actual demand right. Typically in these
arrangements the executive signs a promissory note saying it is a demand note, but in the split dollar
agreement signed at the same time the credit union agrees not to exercise the demand right.6 Taken
together, the documents do not create a loan that is “payable in full at any time on the demand of the
lender.” The IRS looks at the substance of arrangements in totality, and is unlikely to conclude that a
loan that cannot be demanded is a demand loan.7
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Term loans are divided into three categories depending on the length of the term of the loan:
Length of Term – Years
Category
Not over 3 Over 3 but not over 9
Over 9 Short-term
Mid-term
Long-term
Term Loans Without Terms. Some term loans do not state specific dates for repayment, but rather
require the loan to be repaid upon specified events. Tax regulations assign a term to these arrangements.
For example:
Repayment Event
Deemed Term
Termination of employment 7 years
Death
Life expectancy
Having selected either a demand or a term loan, the minimum interest that must accrue on the credit
union’s loan is the IRS-published “applicable federal rate” (AFR) for the type of loan:
Type of Loan
AFR
Demand
Short-term
Mid-term
Long-term
Blended Annual Rate (BAR)
Short-term AFR
Mid-term AFR
Long-term AFR
The IRS sets new short-term, mid-term and long-term AFRs each month, and sets the BAR mid-year.8 For
term loans, the AFR for the month in which the loan is made applies for the duration of the loan. If a term loan
is renewed at the end of the stated term, the AFR resets to the rate in effect for the month of renewal. For
demand loans, the BAR changes each year the loan is outstanding as the IRS annually sets the new BAR.
Since first published in 1985, the BAR and AFRs have varied widely.9 For example, the BAR and longterm AFR histories are as follows:
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The historically low BAR has led some credit unions to use demand loans. This minimizes current taxable
interest income or interest accruals, minimizing the dollars that are diverted from the LRSD so it produces
more supplemental retirement income for the executive and more death proceeds to divide between the
credit union and the executive’s beneficiary. This appears attractive for both parties.
However, selecting the variable BAR for an arrangement that can be in effect for 30 or 40 years could be
shortsighted. The current long-term AFR is lower than what the BAR has been in 22 of the AFR’s 31-year
history. If history repeats itself, locking in the current long-term AFR may prove to be more efficient.
Beyond interest rate considerations, the executive is significantly more secure and likely to have access
to the LRSD values with a term loan than with a demand loan. Under most LRSD designs, the credit
union does not recover its premium loans (and interest, if accrued) until the executive’s death. The board
members who knew the executive and wanted to provide the retirement income to reward excellent
service may have long since been replaced. The executive may be known only as a large receivable
on the credit union’s books. If finances for the credit union become difficult, or a new executive team is
fighting to meet performance objectives to secure their own incentive payments, little may stop the credit
union from calling the loan.
A pre-death call could significantly harm the executive’s finances. Not only would the executive lose a
source of retirement income, but the executive’s personal assets would also be at risk. If policy values
are inadequate, the executive may be required to repay any principal and interest the credit union cannot
recover from the policy (see recourse loan discussion, below). The executive would also be taxed on any
retirement income previously received under the arrangement and on any values the credit union cannot
recover from the policy (if the arrangement is nonrecourse).
The relative advantages of demand and term loans can be summarized as follows:
Demand Loans
Term Loans
Historically low current interest rates Historically low current interest rates
Credit union can call the loan if need arises No interest rate risk
Known interest rate allows more certainty in planning and design
Executive is not at risk of loan being called
Recourse vs. Nonrecourse
The impact of the choice between recourse and nonrecourse LRSD loans may be less obvious than the
demand versus term loan choice, but the consequences can be just as impactful on the financial interests
of the credit union and the executive. The impact is in the allocation of underperformance risks between
the credit union and the executive, and in the credit union’s accounting for the arrangement.
The recourse/nonrecourse choice is an “end-game choice”—its primary impact only arises when the
LRSD ends prematurely and the parties settle up, and then only if the dollars to be divided are less than
the principal and interest on the credit union’s loans. If the loan is recourse, the executive must pay the
shortfall to the credit union. If the loan is nonrecourse, the credit union bears the loss, but the executive
must report the shortfall in taxable income.
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The recourse/nonrecourse choice’s secondary impact is in the accounting for LRSD. Under GAAP, when
the credit union records an asset (receivable) for its premium payment, it must write the value down to
the value of the collateral for the loan.10 If the loan is nonrecourse, the collateral for the loan is solely
the policy’s cash surrender value. Unless the policy is purchased with early cash value riders, the cash
surrender value in early years can be significantly less than the premiums paid. In that case, the loan
is written down on the credit union’s balance sheet. The write down shows up on the profit and loss
statement as a miscellaneous operating expense.
To avoid this write down, some LRSD arrangements require recourse loans. With a recourse loan, the
credit union can count the value of the executive’s recourse guarantee to minimize or eliminate the write
down. GAAP allows counting the guarantee to the extent the credit union has determined the executive
has the resources to make good on the guarantee, and the credit union actually intends to seek recovery
under the guarantee if the need arises.
One additional consequence of the recourse/nonrecourse choice is in implementing the plan. If the
loan is nonrecourse, then to avoid the executive having to report the projected interest value of the loan
in income in the year the loan is made, the credit union and the executive must sign and file a written
statement with their Federal income tax returns11 for each year a premium is paid. The written statement
represents “that a reasonable person would expect that all payments under the loan will be made.”12
In weighing these three consequences of the recourse/nonrecourse choice, credit unions often consider
that the main purpose of the arrangement is to reward long service. Conditioning the size of the
supplemental retirement income on how the policy performs seems consistent with that purpose and with
many deferred compensation plans. Putting not only the benefit but also the executive’s personal assets
at risk of the policy’s underperformance seems a mixed message at best—“Here’s a nice benefit, but if
it doesn’t work you have to pay us lots of money.” This leads most credit unions to take the nonrecourse
approach.
The impact of recourse and nonrecourse loans can be summarized as follows:
Recourse Loans
Nonrecourse Loans
Financial risk for the executive (having to pay shortfall)
Limited financial risk for the executive (having to
pay taxes on any credit union recovery shortfall)
Financial security for the credit union
Financial risk for the credit union (may be
mitigated by cash value rider) Minimizes or eliminates the credit union’s negative Negative accounting impact (reduced by cash
accounting impact
value rider)
Written representation not required to be filed
Written representation required to be filed
Combinations
The demand/term and recourse/nonrecourse options create four possible combinations for LRSD loans.
Many executives would rank the combinations from best to worst as follows:
BestTerm/Nonrecourse
Term/Recourse
Demand/Nonrecourse
WorstDemand/Recourse
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By one measure, the credit union’s perspective would be the inverse. However, part of the calculus in
any such arrangement is arriving at a balance where the costs to the credit union are equal to or less
than the benefits. Having a satisfied executive (within the bounds of fair and reasonable compensation)
can be a huge intangible benefit for the credit union. Another benefit is the prospect of recovering dollars
that, if paid to the executive under a supplemental retirement income plan, would have been unrecovered
expenses. Many credit unions are finding that this cost recovery more than offsets the effects of
committing to leave the dollars in the policy until the executive’s death and accepting the financial risk of
underperformance and any negative accounting impact.
Summary
In the current economic and tax environment, LRSD is an efficient executive compensation planning
option. Careful attention to structuring the underlying loan as demand or term and recourse or
nonrecourse will help balance the parties’ respective risks and rewards.
Learn more about executive benefits, institutional asset management, and benefit liability
management at www.BFBbenefit.com. For more information about this article, please contact
TJ Telford at [email protected] or 801-231-2495.
Endnotes
1. Based on Line 20 Call Reports, growing from 255 credit unions in Q1-2014 to 356 credit unions in Q2-2015.
2. Even though the arrangement may not constitute a loan for other purposes. For example, the underlying policy can be owned
jointly by the executive and the credit union, in which case the credit union never parts with ownership and control of the funds
in the policy, so no legal loan is made. This distinction is important for state-chartered credit unions in states that prohibit officer
loans. Nevertheless, for ease of presentation, in this article we refer to the credit union’s premium payments as loans.
3. The executive could be required to pay some interest and to report the balance in income. For imputed income, the credit union
might also agree to pay a bonus to cover the taxes on the loan, or allow the executive to borrow the taxes from the policy.
4. 26 C.F.R. § 1.7872-15(b)(2).
5. Id. § 1.7872-15(b)(3).
6. For example, the split dollar agreement may have a general “do no harm” clause, such as the parties cannot do anything that
would harm the other’s rights under the arrangement. Demanding the loan would harm the executive’s rights.
7. In Frank Lyon Co. v. United States, 435 U.S. 561, 573, 98 S. Ct. 1291, 55 L. Ed. 2d 550 (1978), the Supreme Court explained:
In applying this doctrine of substance over form, the Court has looked to the objective economic realities of a transaction
rather than to the particular form the parties employed. The Court has never regarded “the simple expedient of drawing up
papers,” Commissioner v. Tower, 327 U.S. 280, 291, 66 S. Ct. 532, 90 L. Ed. 670, 1946-1 C.B. 11 (1946), as controlling for
tax purposes when the objective economic realities are to the contrary. “In the field of taxation, administrators of the laws,
and the courts, are concerned with substance and realities, and formal written documents are not rigidly binding.” Helvering
v. Lazarus & Co., 308 U.S. [252, 255, 60 S. Ct. 209, 84 L. Ed. 226, 1939-2 C.B. 208 (1939).]
8. The IRS sets the BAR assuming the dollars earn interest for the first half of the year at the January short-term AFR, and interest
for the second half of the year at the July short-term AFR. Therefore, the BAR for a year is not set until June when the IRS
announces the July short-term AFR.
9. The AFR history, together with the most recently published rates, are available at www.SPLawFirm.net/afr.
10. EITF Issue No. 06-10, Accounting for Collateral Assignment Split Dollar Life Insurance Arrangements, March 15, 2007.
11. 26 C.F.R. § 1.7872-15(d)(2)(ii). Credit unions do not file “Federal income tax returns” so it is not clear how this requirement
applies to the credit union’s filing requirement. Typically, state-chartered credit unions attach the representation to their Form
990 for the year the premium is paid, and federal credit unions do not file the representation but rather keep it for their records.
12. Id. § 1.7872-15(d)(2)(i).
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